1 Converting Retirement Savings into Income: Annuities and Periodic Withdrawals December 1, 2008 Janemarie Mulvey Specialist in Aging Policy Patrick Purcell Specialist in Income Security Domestic Social Policy Division
2 Converting Retirement Savings into Income: Annuities and Periodic Withdrawals Summary To a worker contemplating retirement, there is perhaps no more important question than How long will my money last? Congress has a strong interest in the income security of older Americans because much of their income is either provided directly from public programs like Social Security, or in the case of pensions and retirement accounts, is subsidized through tax deductions and deferrals. Many retirees must decide how to convert retirement account balances into income and how to preserve the accounts in the face of several kinds of risk.! Longevity risk is the risk that the individual will exhaust his or her account before death and experience a substantial decline in income.! Investment risk is the risk that the assets in which the individual has invested his or her retirement account will decline in value.! Inflation risk is the risk that price increases will cause the individual s retirement income to decline in purchasing power.! Unexpected events such as divorce, the death of a spouse, the cost of medical care, or a need for long-term care services are also risks. There are strategies for dealing with each of these risks, but no single strategy can deal effectively with all of them. For example, purchasing a life annuity insures against longevity risk and it shifts the investment risk to the insurer. However, purchasing an annuity depletes the purchaser s available assets by the amount of the premium. These assets are no longer available to the retiree in the event of a catastrophic illness or other unexpected major expense. To date, the demand for annuities has been low. There are many reasons for the low demand for annuities, but one of the most important has been that many potential annuity purchasers do not value the longevity insurance provided by annuities at its market price. Retirees who choose not to purchase life annuities must decide how much to withdraw from their retirement accounts each year. Because they face uncertainty with respect to both life expectancy and the rate of return on investment, this decision carries its own risks. If withdrawals are too large, retirees risk spending down their savings too quickly, possibly leaving them impoverished. If withdrawals are too small, they might spend too little and leave substantial assets unspent when they die. An analysis conducted by CRS indicates that under specific conditions there is a 95% or greater probability that a man who retires at age 65 will not exhaust his retirement account before the earlier of death or age 95 if his initial withdrawal does not exceed 5% of the account balance and later withdrawals are the same in inflationadjusted dollars. Under the same conditions, there is a 95% or greater probability that a woman who retires at age 65 will not exhaust her retirement account before the earlier of death or age 95 if her initial withdrawal does not exceed 4.5% of the account balance and later withdrawals are the same in inflation-adjusted dollars.
3 Contents Introduction...1 The Nature of Risk in Retirement...2 Longevity Risk...2 Inflation Risk...3 Investment Risk...4 Unexpected Events...5 Annuities as a Source of Retirement Income The Current Market for Annuities...7 Group Annuities...7 Individual Annuities...7 Tax Treatment of Annuities...10 Taxation of Income from a Fixed Annuity Taxation of Income from a Variable Annuity Tax Exclusion for Long-term Care Insurance Consumer Protections and the Regulatory Environment State Regulation of Annuities...12 Federal Regulation of Annuities...13 Why Is Demand for Individual Annuities So Low? Complexity and Lack of Transparency in Annuity Expenses Lack of Flexibility in Dealing with Unexpected Expenses Dying Before Getting Full Value...16 Adverse Publicity and Lack of Knowledge About Annuities Retirement Account Withdrawal Strategies How Long Will a Retirement Account Last with Fixed Annual Withdrawals?...17 Initial Rate of Withdrawal...18 Investment Portfolio...18 Probability of Assets Lasting for at Least a Specific Number of Years...19 Estimates Incorporating Life Expectancy Estimates of Variable Annual Withdrawals Summary of Withdrawal Strategies: Balancing Risks Appendix 1. What is Monte Carlo Analysis? Appendix 2. United States Life Tables, List of Figures Figure 1. Growth in Fixed, Variable and Equity Indexed Annuity Sales Relative to Growth in S&P 500 Index...9
4 List of Tables Table 1. Estimated Percentage of Individuals Age 65 in 2004 Surviving to Selected Ages...3 Table 2. Annual Average Rate of Return Over Ten Year Period (Inflation- Adjusted)...5 Table 3. Monthly Income By Gender and Joint/Survivor Option for Fixed Annuity With a $100,000 Premium, Table 4. Tax Treatment of Annuities...12 Table 5. Estimated Probability a Retirement Account Will Last for at Least a Specific Number of Years...20 Table 6. Probability of Retirement Account Lasting to at Least a Given Age, Including Mortality Risk, Retirement at Age Table 7. Probability of Retirement Account Lasting to at Least a Given Age, Including Mortality Risk, Retirement at Age Table 8. Probability of Retirement Account Lasting to at Least a Given Age, Including Mortality Risk, Retirement at Age Table 9. Variable Annual Withdrawals Based on Life Expectancy, Retirement at Age Table 10. Variable Annual Withdrawals Based on Life Expectancy, Retirement at Age Table 11. Variable Annual Withdrawals Based on Life Expectancy, Retirement at Age
5 Converting Retirement Savings into Income: Annuities and Periodic Withdrawals Introduction The 78 million members of the baby boom generation are beginning to retire. 1 After many years of accumulating assets to spend in retirement, they now must decide how to convert these assets into a steady stream of income. Because of the trend away from defined benefit (DB) pensions to defined contribution (DC) plans such as 401(k) plans future retirees will be less likely to have a guaranteed stream of income from defined benefit pensions. Furthermore, while Social Security will provide a guaranteed income to most retirees, it will replace only a relatively small 2 proportion of their pre-retirement income. As a result of these trends, many future retirees will rely greatly on their savings to finance their consumption during retirement. A retiree who is deciding how to convert wealth into retirement income will have to balance many risks. Increases in average life expectancy will mean that future retirees will have to ensure that their wealth will last through a retirement that could span 30 or 40 years. Increased volatility in equity markets, the effects of inflation on purchasing power, and the possibility of substantial expenses for medical treatment and long-term care will further complicate this decision. There are a number of ways to convert retirement wealth into income. One option is to purchase a life annuity from an insurance company. In exchange for payment of an initial premium, a life annuity pays a guaranteed income throughout 3 retirement, regardless of how long the purchaser lives. Life annuities represent only about five percent of individual annuities sold in the United States. Most annuities sold in the U.S. are deferred annuities, which are tax-deferred retirement savings accounts. At retirement, a deferred annuity can be converted to a life annuity; yet, relatively few deferred annuities are converted to life annuities. Likewise, most individuals who have accumulated retirement savings in 401(k) plans or individual retirement accounts (IRAs) choose to access these funds through lump-sum distributions or periodic withdrawals rather than by purchasing a life annuity. 1 The Bureau of the Census defines the baby boom as people born between 1946 and The Social Security Administration estimates that Social Security replaces about 55% of earnings for a career-long low-wage worker, 41% of earnings for a career-long median-wage worker, and 27% of earnings for a career-long high-wage worker. 3 Life annuities are also sometimes called immediate annuities. This report uses these terms interchangeably.
6 CRS-2 There are many reasons why relatively few retirees choose to purchase a life 4 annuity as a source of retirement income. Among these reasons are that:! most retirees receive annuity income from Social Security;! about one-third of retirees receive annuity income from defined benefit pensions;! the fees charged by annuity providers can be high and the fee structure is not transparent;! purchasing an annuity reduces the assets available to the retiree to meet unexpected expenses, and breaking the contract is costly; and! there have been instances of deceptive sales practices by some agents, many of whom receive large commissions for each sale. Another option for converting retirement savings into income is to take periodic withdrawals from a retirement account. Some retirees attempt to self-annuitize by basing the amount of each periodic withdrawal from the account on their remaining life expectancies. Retirees who self-annuitize take on the responsibility of managing their investments and also the risk that they will live longer than average. This report has two sections. The first section describes four kinds of risk that retirees face in retirement: longevity risk, investment risk, inflation risk, and the risk of large, unexpected expenses for medical care or long-term care. It then describes the basic features of life annuities and examines some of the reasons that the market for these annuities remains small, in spite of the protection that they provide against outliving one s retirement assets. The second section of the report describes various strategies for self-annuitizing and presents the results of an analysis that CRS conducted to estimate the probability that an individual who elects to self-annuitize would exhaust his or her retirement assets before death. The Nature of Risk in Retirement Decisions about how to draw down assets in retirement must take into account many risks. These include longevity risk (i.e., the risk that one will live beyond the average life expectancy), inflation risk, investment risk, and the risk associated with unexpected financial shocks from widowhood, divorce, medical care, or the need for long-term care services. Longevity Risk The U.S. population is living longer than previous generations. A man who reached age 65 in 1960 could expect to live another 13.0 years, while a woman who turned 65 in 1960 had a remaining life expectancy of 15.8 years. A man who reached age 65 in 2004 could expect to live another 17.1 years, while a woman who turned 4 Some individuals choose not to spend assets because they wish to leave the assets as a bequest to their heirs. However, given that an individual chooses to spend some or all of his or her retirement savings, the relevant question for this analysis is why relatively few choose to do so by purchasing a life annuity.
7 CRS in 2004 had a remaining life expectancy of 20.0 years. Looking beyond the averages, more than one-fourth of women who reach age 65 are likely to live to age 90, and 12.4% are likely to live to age 95. One out of six men who attain age 65 will live to age 90, and an estimated 6% will live to age 95. (See Table 1). Individuals who underestimate the likelihood of living into very old age might spend their assets too quickly, depleting their savings while they still have many years to live. This could lead to a decline in their standard of living, and possibly to increased reliance on public assistance programs. Table 1. Estimated Percentage of Individuals Age 65 in 2004 Surviving to Selected Ages Percent Surviving to Age: Total Male Female % 60.3% 72.7% % 46.5% 61.0% % 30.6% 45.4% % 15.9% 27.8% % 5.8% 12.4% % 1.3% 3.5% Source: U.S. National Center for Health Statistics, National Vital Statistics Report, United States Life Tables, 2004, Vol. 56(9), (Dec. 2007). Inflation Risk As overall prices in the economy rise over time, the purchasing power of income declines unless income increases at the same rate that prices increase. Few pensions in the private sector provide regular cost-of-living increases. Data collected by the Department of Labor indicate that fewer than 5% of pensions in the private sector provide regular cost-of-living adjustments to retirees. Retirees must account for the potential impact of inflation on their investment portfolios as they decide how to draw down their retirement wealth. Social Security is one of the few sources of retirement income that is fully inflation-indexed each year. Yet, even Social Security s annual cost-of-living adjustments may not fully protect retirement income from the effects of inflation. The annual cost-of-living adjustment for Social Security is based on the increase in the overall level of prices. Prices for some categories of expenditures that the elderly use at higher rates than younger consumers such as health care have been growing faster than overall prices. Over the period from 1980 to 2007, the average annual rate of inflation for goods and services averaged 3.5%, but prices for medical care rose 6 at an average annual rate of 5.9%. For those who have above-average out-of-pocket health care expenditures, these price increases can significantly reduce the amount 5 U.S. National Center for Health Statistics, National Vital Statistics Report, United States Life Tables, 2004, Vol. 56(9), (Dec. 2007). 6 From 1980 to 2007, the Consumer Price Index (CPI) for all goods and services rose from 82.4 to while the CPI for medical care rose from 74.9 to See Council of Economic Advisers, Economic Report of the President, February 2008, Table B-60, p. 295.
8 CRS-4 of income available for other expenditures. In addition, Medicare Part B premium increases are tied to program cost increases which have historically exceeded growth 7 in general inflation. By 2025, these premiums are expected to equal over 50% of the 8 average Social Security benefit, as compared to 27% in Investment Risk Investment risk is the possibility that an individual s retirement assets might decline in value because specific stocks, bonds, or other assets depreciate. Diversification can reduce investment risk, because declines in the value of some assets are likely to be fully or partially offset by gains in the value of other assets. Stock and bond mutual funds, for example, help protect individuals from investment risk by purchasing securities from many companies in a variety of industries. In a mutual fund, investment losses from companies that are performing poorly may be offset by investment gains from companies that are performing well. Investment risk includes market risk, which is the possibility that an individual s retirement assets will decline in value because of an overall decline in asset prices, as when the stock market falls. Even a well-diversified portfolio of stocks will not protect the value of an individual s retirement from depreciating if stock values fall across the board, as they have in Although a diversified portfolio can moderate investment risk, there have been extended periods of time when declines in the stock market and low interest rates resulted in negative returns on investment. For example, between 1929 to 2006 there were 14 ten-year periods of negative annual rates of return after adjusting for inflation. Table 2 shows the five worst of those 14 ten-year periods. There have also been instances when negative rates of return spanned 15 years. Between 1966 and 1981, real rates of return on stocks averaged -0.4%, and the average annual real rate of return on shortterm government securities was -0.2%. Those who retire at the beginning of a 9 period of negative returns could face significant reductions in retirement wealth. 7 See CRS Report RL33364, The Impact of Medicare Premiums on Social Security Beneficiaries by Kathleen Romig. 8 CRS estimates based on data reported in CMS Office of the Actuary Memorandum, Additional Information Regarding Comparisons of Beneficiary Income and Out-of-Pocket Costs For Medicare Supplementary Medical Insurance. March 25, nd Siegel, Jeremy J. Stocks for the Long-Run. 2 ed. New York: McGraw-Hill
9 CRS-5 Table 2. Annual Average Rate of Return Over Ten Year Period (Inflation-Adjusted) Portfolio Mix Time Period 65% Stocks/35% Bonds 65% Bonds/35% Stocks 1968 to % -1.8% 1972 to % -1.7% 1964 to % -1.3% 1971 to % -1.6% 1938 to % -3.4% Source: CRS analysis of data from Ibottson Associates. Unexpected Events Unexpected events can adversely affect retirement income. These include losing a spouse through death or divorce, high medical expenses, and the need for long-term care services. According to a recent study by the Urban Institute, more than two-thirds of adults age 70 and older experienced at least one such financial shock over a nine-year period. Widowhood occurred among nearly one-third of married adults over age 70. The study found that widowhood was more likely to 10 reduce women s wealth than men s wealth. Unexpected health care costs can also reduce retirement wealth. Although the majority of retirees are covered by Medicare, deductibles and co-payments can be significant for those who are seriously ill. Medicare provides only limited coverage for long-term hospital stays and nursing home care. A recent analysis of the Health and Retirement Survey found that 6% of households aged paid more than 50% 11 of their income for out-of-pocket medical expenses. These costs can be especially high at the end of life when a surviving spouse may face large medical bills and an accompanying reduction in retirement income. A study in 2002 found that out-ofpocket costs for end-of-life medical expenses could average about $23,000 (adjusted 12 to 2007 dollars). While the introduction of Medicare Part D may offset some of these costs, even under this program an individual who is not eligible for a lowincome subsidy could be responsible for more than $6,000 in copayments for prescription medicines in Johnson, R., et al. When the Nest Egg Cracks: Financial Consequences of Health Problems, Marital Status Changes, and Job Layoffs at Older Ages, Urban Institute, Jonathan Skinner, Are You Sure You re Saving Enough for Retirement? Journal of Economic Perspectives, 21(3), (Summer 2007), p Hoover, D., S. Crystal, R. Kumar, U. Sambamoorthi, and J. Cantor, Medical Expenditures During the Last Year of Life: Findings from the Medicare Current Beneficiary Survey, Health Services Research, 37(6), p , 2002.
10 CRS-6 13 Another potential economic shock is the cost of long-term care services. It has been estimated that over two-thirds of individuals aged 65 and older will require long-term care services at some point in their lives. In 2008, the annual average cost of a nursing home stay is $68,255 for a semi-private room and $76,285 for a private 14 room. These costs greatly exceed the 2007 median income of $29,730 among households in which either the householder or householder s spouse was 65 or 15 older. Medicare does not cover extended stays in nursing homes, and Medicaid coverage generally is available only to individuals who are poor or become poor by 16 spending down their assets on long-term care services. For those who are not Medicaid-eligible and who have not purchased private long-term care insurance, long-term care costs must be paid out-of-pocket. Annuities as a Source of Retirement Income A life annuity also called an immediate annuity is an insurance contract that provides income payments on specified dates in return for an initial premium. Life annuities can help protect retirees against some of the financial risks of retirement, especially longevity risk and investment risk. Life annuities pay income to the purchaser for as long as he or she lives, and in the case of joint-and survivor annuities, for as long as the surviving spouse lives. In addition, some annuities offer limited protection against inflation through annual increases. However, the annual increases must be paid for by accepting a lower initial monthly annuity income. Other annuities allow the purchaser to share in the investment gains from growth in equity markets as a way to offset the effects of inflation; however, such annuities also require the purchaser to share in the investment losses if markets fall. Despite the potential advantages of annuities in reducing longevity risk and investment risk, life annuities continue to represent a small proportion of all annuities sold in the U.S. In recent years, deferred annuities used as tax-deferred savings 17 vehicles have outsold life annuities by a ratio of almost 20 to 1. As noted earlier, the irrevocable nature of annuity contracts appears to be an important factor in dissuading many retirees from purchasing life annuities. Although insurers have devised options to assure that the payments will continue after the purchaser s death joint-and-survivor annuities, and term-certain annuities, for example these options add to the cost of the annuity. Because of the projected increase in the number of older Americans over the next 20 years, and the concurrent increase in the 13 Long-term care refers to a broad range of medical, personal, and supportive services needed by individuals who can no longer care for themselves due to physical or cognitive impairments. 14 Genworth Financial 2008 Cost of Care Survey, April This median income is based on the 99% of households with any income. See CRS Report RL32697, Income and Poverty Among Older Americans in 2007, by Patrick Purcell. 16 The Medicaid statute prohibits individuals from transferring their assets to others in order to qualify for Medicaid. The law also protects some of the income and assets of the community spouse of a nursing home resident so that he or she is not impoverished. 17 National Association of Variable Annuities, 2007 Factbook.
11 CRS-7 potential market for life annuities, insurers are likely to continue to add features to their annuity products in an attempt to broaden their appeal to retirees. The Current Market for Annuities Annuities are either provided through employer-sponsored pension plans (the group market) or are purchased directly by individuals (the individual market). Group Annuities. Annuities from defined-benefit pensions can protect retirees from investment risk and longevity risk. The benefit formula under most defined benefit pensions is based on the worker s years of service and final average salary. The individual s benefit does not vary with investment returns, nor does it 18 decrease as a result of increases in average life-expectancy. The employer that sponsors the plan bears both the investment risk and the longevity risk. If investment returns fall below expectations, or if the plan s actuaries project increases in life expectancy, the plan sponsor must provide additional funding to the plan to meet these costs. Since the mid-1980s, the proportion of workers who retire with a defined benefit pension has declined substantially. The number of workers participating in defined benefit pension plans fell from 26.9 million in 1985 to million in 2006, a decline of 23%. Another reason for the decline in the number of workers retiring with an employer-sponsored annuity has been an increase in the number of defined benefit plans that offer the option of taking a lump-sum rather than an annuity. Of all those who are covered under a defined benefit plan, more than half are offered the choice 20 between a lump sum and an annuity. When offered this choice, many individuals choose the lump-sum option. According to a study by the Vanguard Group, only 40% of defined benefit plan participants who are offered a lump-sum choose to 21 receive an annuity. Given these trends, the share of retirement income that will be guaranteed in the form of a defined benefit annuity is likely to decline in the future. Individual Annuities. Annuities purchased directly from insurance companies or from insurance agents or brokers by individuals are called individual annuities. Two features that vary across individual annuities are the timing of payments and the rates of return. Timing of Payments. Annuities can either be deferred, in that premiums are paid and assets are accumulated while the individual is working and payment of income is deferred until the worker retires, or immediate, in which a single premium is paid in exchange for lifelong stream of income that begins immediately. A deferred annuity is similar to a savings account in which individuals can accumulate money over time. Investment earnings accrue on a tax-deferred basis. Deferred annuities represent nearly 95 percent of annuity sales. While individuals 18 Although annuity payouts vary depending on the age of retirement, these payouts are not tied to an individual s own life expectancy but rather that of a group of individuals Pension Benefit Guaranty Corporation, Pension Insurance Data Book, Bureau of Labor Statistics, 2007 National Compensation Survey. 21 G. Mottola, and S. Utkus, Lump Sum or Annuity? An Analysis of Choice in DB Pension Payouts, Vanguard Center for Retirement Research, Volume 30, November 2007.
12 CRS-8 holding a deferred annuity can convert the funds into a guaranteed stream of income in retirement, most take a lump-sum payment or a series of periodic withdrawals. 22 An immediate annuity provides a guaranteed monthly income for a specified period of time in exchange for a one-time premium payment. Income from an annuity can be either fixed or variable. Income from an annuity may be a received for specific number of years, as with a term certain annuity, for the life of the annuitant, as in a single-life annuity, or for the lives of both the annuitant and his or her spouse, as in a joint and survivor annuity. Under a joint and survivor annuity, the surviving spouse is eligible to receive income until he or she dies. The survivor benefit is typically 50%, 75%, or 100% of the income received while the annuity purchaser was living. As noted earlier, while immediate annuities can protect retirees from longevity risk and transfer the investment risk to the insurer, only 5% of 23 individual annuities currently sold are immediate annuities. Table 3 shows some examples of monthly income from an immediate annuity. Most annuities purchased in the private sector provide different incomes for men and women. Men can purchase an annuity with a higher monthly income than women for the same premium because the average life expectancy of a man is lower than for a woman of the same age. The average lifetime values of the annuities for a man and woman of the same age would be equal. Employer-sponsored pension plans must 24 offer unisex annuities to retirees. Under a unisex annuity, a man would receive a lower monthly annuity income than he would get from a gender-based annuity, reflecting the higher average life expectancy of a group that includes both men and women. Likewise a woman would receive a higher monthly annuity income from a unisex annuity than she would receive would from a gender-adjusted annuity. Table 3. Monthly Income By Gender and Joint/Survivor Option for Fixed Annuity With a $100,000 Premium, 2008 Unisex Male Female Age 60 Single Life $690 $716 $666 Joint and Survivor $645 $656 $645 Age 65 Single Life $714 $801 $734 Joint and Survivor $657 $721 $707 Age 70 Single Life $869 $917 $828 Joint and Survivor $810 $811 $793 Source: Based on CRS Annuity Calculator. Assumes fixed real (inflation-adjusted) rate of return equal to historical average of 2.8%, and no added adjustments for adverse selection. Rates of Return. Annuities are similar to other investment vehicles in that purchasers earn a rate of return on their premium investment. The rate of return on National Association of Variable Annuities, 2007 Factbook. National Association of Variable Annuities, 2007 Factbook. 24 The United States Supreme Court ruled in 1983 that under federal civil rights statutes, employer-sponsored retirement plans cannot offer annuities that differentiate on the basis of gender. See Arizona Governing Comm. v. Norris, 463 U.S (1983).
13 CRS-9 the annuity can be fixed, indexed, variable, or some combination of the three. The risk, regulation and fee structure varies across these different types of annuities. A fixed annuity pays a fixed monthly payment for the term of the annuity. The amount of the monthly payment is determined at the time the annuity is purchased. The income that any given premium amount will purchase depends mainly on the age of the purchaser (and the age of the purchaser s spouse in the case of a joint and survivor annuity) and prevailing market interest rates for medium-term bonds at the time the annuity is purchased. In 2007, fixed annuities represented 22% of annuity sales. 25 Figure 3. Growth in Fixed, Variable and Equity Indexed Annuity Sales Relative to Growth in S&P 500 Index Source: CRS estimates based on data from National Association of Variable Annuity, 2007 Annuity Factbook. Data on growth in equity markets based on annual rate of return of S&P index reported by Ibbotson Associates. A variable annuity offers annuity purchasers a choice of a wide range of investment options that can vary in value over time. The investment options can include stocks, bonds and money market portfolios. The monthly income provided by a variable annuity will fluctuate according to the investment performance of the funds in which the annuity premium is invested. Income from a variable annuity can decline if the investment underlying the annuity loses value. Some variable annuity policies offer limited protection against declines in value through a guaranteed minimum income. In 2007, the majority of annuity sales (67%) comprised variable annuities. 26 An equity-index annuity earns a rate of return based on the performance of an equity index fund. Examples of equity indexes used include Dow Jones Industrial Average, Lehman Brothers Aggregate U.S. Index, and Standard and Poor s (S&P) 500 Composite Stock Price Index. If the underlying index declines, the income provided by the annuity will also decline. To reduce this risk, the insurer in some cases may provide a guaranteed minimum payment to protect the consumer against market fluctuations. This minimum, however, costs more to annuity purchasers by National Association of Variable Annuities, 2007 Factbook. Ibid.
14 CRS-10 reducing their initial annuity income. In 2007, 11% of annuity sales were indexed 27 annuities. The demand for each type of annuity is influenced by rates of return in equity markets. A strong equity market reduces demand for fixed annuities while a weak stock market increases demand for fixed annuities. During the strong equity market in late 1990s, growth in variable annuities sales exceeded growth in fixed annuity sales. By early 2000, when equity markets were earning negative rates of return, the demand for variable annuities fell. After 2000, growth in variable annuity sales dominated the market. (See Figure 1.) Inflation Protection Options. Inflation-indexed annuities preserve the purchasing power of annuity income by providing a lifetime stream of income that increases with inflation. Treasury Inflation Protected Securities (TIPS) could be used as an investment vehicle by insurers that would like to offer inflation-indexed annuities, but few U.S. insurers offer such annuities. Potential purchasers have proven unwilling to accept a substantially lower initial payment in exchange for protection against inflation. Some insurers offer graded annuities that provide annual increases in payments, which are typically capped at 3%, but graded annuities do not fully protect against inflation that exceeds the annual cap. Tax Treatment of Annuities The taxation of an annuity differs between the accumulation phase and the payout phase. Deferred annuities receive favorable tax treatment in the accumulation phase. Returns on investment are not taxed in the year they are earned. During the payout phase, taxation of annuity income differs between payments taken as withdrawals and payments taken as a life annuity. In either case, annuity income is 28 taxed at ordinary income tax rates rather than at capital gains tax rates. The taxation of annuity income depends on whether the income is received as:! a single lump sum,! a series of withdrawals that are not annuitized, or! a life annuity (either variable or fixed). When funds are withdrawn as a lump sum, the amount of the distribution that exceeds the amount the annuity owner invested is subject to taxation at the owner s 29 ordinary income tax rate. If money is taken out of the annuity in a series of withdrawals, each withdrawal is considered to consist of investment earnings until 27 National Association of Variable Annuities, 2007 Factbook. 28 The long-term capital gains tax rate, as enacted in the 2003 Jobs and Growth Tax Relief Reconciliation Act, is 15%. Annuity withdrawals are taxed at the marginal tax rate for ordinary income, which could be higher than the capital gains tax rates. 29 Annuities purchased in the individual market are purchased with after-tax income. The amount of any distribution from an annuity that represents a return to the purchaser of his or her own premium payments is not taxed a second time.
15 CRS all investment gains have been withdrawn. The taxation of annuity income is summarized in Table 4. Taxation of Income from a Fixed Annuity. Each payment from a fixed annuity is treated as consisting partly of the investment gains, which are taxable, and partly as a return of principal, which is not taxable. The proportion of each payment that is excluded from taxable income is determined by dividing the amount that the individual paid into the annuity by the total amount that would be paid out over an average life expectancy, according to life tables published by the Internal Revenue Service. Each payment is multiplied by this ratio to determine the fraction of the annuity payment that is not subject to income taxes. For example, consider an individual who has paid a $100,000 premium for an immediate annuity at age 65. In November 2008, a 65 year-old male would receive monthly income of about $675 for a premium of $100,000. IRS life tables indicate that, on average, the purchaser 31 will receive annuity payments for 20 years. The total expected lifetime income 32 from the annuity therefore would be $162,000. The proportion of each payment that would be excluded from taxable income would be 100,000/162,000, or 61.7%. The other 38.3% percent of each payment would be subject to income taxes. Taxation of Income from a Variable Annuity. With a variable annuity, income varies with the performance of the underlying investments. The amount of income from a variable annuity that is excluded from taxable income is computed by dividing the premiums paid for the annuity by the number of years that payments are expected to be made to the annuitant. For a life annuity, this would be the annuitant s life expectancy as determined using IRS tables. In the case of a 65 yearold who had paid a premium of $100,000, the amount of each monthly annuity 33 payment that would be excluded from taxable income would be $416. Tax Exclusion for Long-term Care Insurance. An exception to the taxation of annuity income was included in the Pension Protection Act of 2006 (P.L ). Beginning in 2010, withdrawals from annuity contracts that are used to pay for qualified long-term care insurance premiums are not subject to income tax. However, the investment in the annuity contract is reduced by the amount of the long-term care insurance premiums. This means that a larger percentage of the future income received from the annuity will represent investment gains and will be subject to income taxes. 30 For example, if someone invested $25,000 in a deferred annuity and the value of the annuity when he or she begins to take withdrawals is $50,000, the first $25,000 withdrawn is taxable as ordinary income. The remaining $25,000 is not taxed because it is considered a return of principal to the purchaser See IRS Publication 939, General Rule for Pensions and Annuities, Table 5, p x 12 x 20 = 162,000. At 65, the individual s life expectancy is 20 years, or 240 months. 100,000/240 = 416.
16 CRS-12 Table 4. Tax Treatment of Annuities Type of Account Individual s Contributions Investment Returns Withdrawals Deferred Annuity After-tax Tax-Deferred Amounts in excess of contributions are taxed as ordinary income Immediate Annuity Defined Benefit Pension After-tax Not applicable Amounts in excess of contributions taxed as ordinary income a Varies Tax-deferred Amounts not previously included in taxable income taxed as ordinary income Source: Congressional Research Service. a. In the private-sector, employee contributions are rarely required. Federal employee pension contributions are made with after-tax income. Tax treatment of pension contribution by state and local employees varies by locality. Consumer Protections and the Regulatory Environment Consumer protections are intended to ensure that information used to sell an annuity is truthful, and that individuals who purchase an annuity fully understand the future consequences with respect to retirement income. The key challenge in the development and enforcement of consumer protections is that some annuity products are regulated exclusively at the state level while others are also regulated by federal agencies. Because state governments have primary jurisdiction over regulation of fixed annuities, there is wide variation in regulation across states. Further, while variable annuities are regulated by the federal Securities and Exchange Commission (SEC), equity-index annuities, which are designed to track the performance of a common stock index, such as the S&P 500 or the Russell 2000, are regulated primarily by the states. State Regulation of Annuities. Like other insurance products, most annuities are regulated by the states. State laws govern the organization and licensing of insurance companies and their agents and state insurance departments oversee insurance company operations. These state laws and regulations also govern marketing and sales practices as well as insurer requirements. To help guide states in their oversight efforts, the National Association of Insurance Commissioners (NAIC) has developed language for model laws and regulations to provide guidelines for legislators to modify and adopt in their respective states. The NAIC Model Act has not been uniformly adopted across states, thus leaving potential gaps in consumer protections. As of February 2008, states have not adopted the NAIC model regulations on suitability. The NAIC 34 American Council of Life Insurers, Life Insurers Initiative to Improve the Annuity Sales (continued...)
17 CRS-13 Model Suitability language requires insurance companies to give objective financial information to potential purchasers, and it requires agents to use a standardized form to determine whether an annuity would be suitable for the potential purchaser. Some state laws ban the use of professional designations or titles such as Senior Financial Advisor that might mislead senior consumers into thinking the advisor has special financial expertise related to the needs of older consumers. A similar problem exists with respect to disclosure requirements in annuity contracts. The NAIC Annuity Disclosure Model Regulation requires certain information to be disclosed, including information about premiums and how they are charged, a summary of the options and restrictions for accessing money, and an outline of fees. According to the NAIC, 35 states have adopted the NAIC disclosure regulation. The states also play a role in protecting annuity owners against the insolvency of annuity insurers. To do this, each state has a state guaranty association to provide a financial safety net for each line of insurance and to ensure that coverage continues if an insurer becomes insolvent. State laws require insurers to become members of the guaranty associations in every state in which they are licensed to do business. The actual coverage for annuity contracts varies from state to state, but cash values and annuity benefits are usually protected up to at least $100,000. However, coverage is not provided for variable annuity contracts. Variable annuity contracts are held in separate accounts by insurers and they are protected from the general creditors of the insurance company in the event of insolvency. Although the Securities Investor Protection Corporation (SIPC) protects against fraud in variable annuity sales, it does not provide any relief to investors whose variable annuities decline due to falling prices in equity markets. Federal Regulation of Annuities. Because the assets underlying variable annuities are invested in equities, they are regulated by the federal government through the Securities and Exchange Commission (SEC). Equity-index annuities, which are based on market indexes, are not yet regulated by the SEC (see discussion below). Federal securities laws require certain disclosure documents, including a prospectus, to be given to investors. Certain disclosure documents must also be filed with the SEC. In addition, written marketing materials, such as advertisements, are subject to federal regulation. Federal law prohibits agents who sell variable annuities from making untrue statements of material fact or failing to state a material fact that is necessary to 35 prevent the statement from being misleading. Annuity agents also have a fiduciary duty to provide full and fair disclosure of all material facts to their clients and their prospective clients, including all statements in advertising materials. Currently, equity-index annuities are regulated by the states, rather then the SEC. To address this inconsistency in regulation between variable and equity-index annuities, the Securities and Exchange Commission has issued a proposed regulation that would 34 (...continued) Environment, Factsheet, February Section 17(a) of the Securities Act of 1934, Section 10(b) of the Exchange Act and Rule 10b-5, and Section 206 of the Investment Advisors Act of 1940
18 CRS-14 extend federal securities laws with respect to full and fair disclosure and sales 36 practice protections to certain equity-index annuities. Why Is Demand for Individual Annuities So Low? Despite some of the potential advantages of individual life annuities, immediate annuities remain a small part of retirement assets held in the U.S. Of those who 37 purchased immediate annuities in 2003, the median age of purchase was 70. The Internal Revenue Code requires owners of individual retirement accounts to begin taking withdrawals from their accounts and including the withdrawals in their taxable income no later than April of the year in which they reach age 70½. Some owners of IRAs use immediate annuities to meet the requirement to take these required minimum distributions from their retirement accounts. Without this requirement, demand for annuities might even be lower. There are several reasons why the demand for annuities is low despite the aging of the population. Some potential purchasers may already feel they have a sufficient amount of annuitized income from Social Security, and about a third of people 65 and older also have annuity income from defined benefit pensions. Another reason may be the amount and non-transparency of fees and expenses charged by insurance companies. Further, annuity contracts are not easily canceled, and many individuals fear that after purchasing an annuity they may later need a large sum of money to pay for unexpected expenses, such as long-term care or health expenses. Even among people who understand that it is important to insure against longevity risk, some fear that they will die before reaching their normal life expectancy, and will end up losing the bet with the insurance company that sold the annuity. Finally, recent adverse publicity about deceptive sales practices in the annuity market has added to concerns among potential buyers of immediate annuities. Complexity and Lack of Transparency in Annuity Expenses. Annuity providers impose a number of fees and expenses that are complex and are not transparent to the annuity purchaser. Even a rather simple prospectus identifying 38 the various fees can be more than 50 pages long. Fees and expenses fall into three main categories: surrender charges, investment fees, and insurance charges. Fees and expenses vary depending on the type of annuity (fixed or variable). Both fixed and variable annuities have surrender charges, which are fees for cancelling the contract before a specified number of years have passed. A typical surrender charge starts at 7% of the premium in the first year of the contract 36 See CRS Report RS22974, Annuities and the Securities and Exchange Commission Proposal Rule 151A by Baird Webel. 37 M. Drinkwater, Annuitization Study: Profiles and Attitudes, LIMRA International, Best s Review, Tis a Gift to be Simple: Complex Annuities Scare Off Both Buyers and Advisers, So the Industry is Offering Less Intimidating Products, April 1, 2006.
19 CRS-15 and declines by 1% a year until it reaches zero. However, a few companies have surrender charges of up to 15% to 25% of the annuity premium. 39 Variable annuities have two additional fees associated with managing assets. These are investment management fees and insurance charges. Investment management fees cover the cost of managing the different funds across investment accounts. Investment fees vary depending on the type of investment portfolio chosen. Insurance charges include administration, sales commissions, and mortality and expense charges. Mortality and expense charges average 1.15% of the average value of investment and cover three components of the insurance guarantee:! Mortality premium or guarantee of income over one s lifetime;! Death benefit to protect beneficiaries (also called survivor benefit); and,! The cost of the minimum income guarantee. These fees vary by product design. Typically, a fixed annuity with a joint and survivor option is subject to all three components. However, a variable annuity without a joint and survivor option and no minimum guarantee would only be subject to the mortality premium. It is difficult for consumers to identify and understand each fee charged for an annuity. Each insurer has a different format for disclosing information. The insurance industry has recognized this problem and has begun to standardize fee disclosure. A group of insurance organizations is working to develop a simple, standardized disclosure document that presents information about fees in a consumerfriendly 40 manner. Another factor affecting the cost of annuities is that people who buy annuities tend to be those who expect to live longer than average. A person who chooses to purchase an annuity may have information about his or her health, habits, or family history that the insurance company does not have regarding their risk of living longer than average. This phenomenon, called adverse selection, leads to higher annuity premiums than insurers would otherwise have to charge if longevity risk were spread over the entire population. Estimates of the cost of adverse selection vary. Some studies have found that adverse selection reduces income to annuity purchasers by 41 4 cents to 10 cents per dollar of premiums paid. A more recent study defined potential annuitants more narrowly to only include those with sufficient wealth to purchase an annuity. When re-defined in this manner, potential annuitants tend to live considerably longer than average and thus would receive a better deal from an annuity than the average person. According to this analysis, the impact of adverse 39 Testimony of Minnesota Attorney General Lori Swanson Before the Senate Special Committee on Aging on Advising Seniors About Their Money: Who is Qualified and Who is Not? September 5, Members of this group include: American Council of Life Insurers, National Association of Variable Annuities, National Association of Insurance and Financial Advisors, and the National Association of Independent Life Brokerage Agents. 41 Mitchell, Olivia, James Poterba, Mark Warshawsky, and Jeffrey Brown, New Evidence on the Money s Worth of Individual Annuities. American Economic Review 89(5), 1999.
20 CRS-16 selection on annuity prices is only about half as great as previously estimated, or 42 about 2 cents to 5 cents per premium dollar. If participation in individual annuities were broader, the effect of adverse selection would be reduced and annuitants income would be higher. Lack of Flexibility in Dealing with Unexpected Expenses. Once an individual purchases an immediate annuity, the decision is not easily reversible. Most states require a 10-day look back period during which a buyer can change his or her mind, but after this, canceling an annuity contract will result in substantial surrender charges. Part of the lack of flexibility in annuity contracts was recently addressed in the Pension Protection Act of 2006, which allows funds used to purchase an annuity to be withdrawn tax-free to buy long-term care insurance. It is important to note that long-term care insurance must be purchased well in advance of actually needing long-term care services. Annuity owners would have to make the decision to purchase long-term care insurance in the early years of the payout phase. Dying Before Getting Full Value. Annuity buyers pay for the insurance component of the annuity, which guarantees a monthly income no matter how long the annuitant lives. Some people are reluctant to purchase an annuity out of fear that they will die before they get back the premiums that they paid into it. Joint and survivor annuities and term-certain annuities can assure that annuity payments will continue even if the purchaser dies earlier than he or she expected, but these options reduce the monthly payments that the annuitant receives while he or she is living. Adverse Publicity and Lack of Knowledge About Annuities. Another factor affecting current demand for annuities may be adverse publicity surrounding false advertising and deceptive sales practices employed by insurance agents selling equity-index annuities. These practices may have led some consumers to avoid all annuity products. Equity-index annuities, however, currently account for only 11% of annuity sales. Further, recent proposals by the SEC to strengthen regulations for sales of equity-index annuities may help to alleviate consumers concerns in the future. Retirement Account Withdrawal Strategies Although annuities offer protection from longevity risk and investment risk, relatively few people use their retirement savings to purchase an annuity. Most people choose instead to take periodic withdrawals from their retirement accounts. Individuals who purchase life annuities transfer the responsibility for managing assets and the risk of outliving their assets to an insurance company. In contrast, retirees who self-annuitize take on the responsibility of managing their investments and also the risk of living longer than average. Annuity purchasers, however, give up control over the assets that they use to purchase their annuities, while those who take periodic withdrawals have the money in their retirement accounts available to meet large, unexpected expenses that may arise during retirement. 42 Webb, Anthony. Is Adverse Selection in the Annuity Market A Big Problem? Issue Brief, Center for Retirement Research at Boston College, January 2006, Number 40.
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